Every Monday is Intents and Purchases day at Living Behind the Curve

“You cannot help but look when the stock market is dodging into a ditch. It’s like those celebrity mug shots, or CEO perp walks. We look.” -Susan Tompor of the Detroit Free Press. Check out the rest of her excellent article here.

It’s a funny thing, this world we live in. I just started contributing to my 401k plan a couple of weeks ago, right in time to watch the entire country panic over fluctuations in the stock market. I’m sure you’ve heard about the stumbles the market and the major indexes have endured over the past few weeks. We’ve been hearing over and over again that the market has lost 6% over either a week or a couple of weeks, that the Dow has lost several hundred points while the S&P is chugging along pretty much fine, and the NASDAQ is screaming along like NASCAR. (I’ve always wanted to say that.)

There’s a lot of conflicting information out there that just doesn’t resolve into anything comprehensible to the layman. The President was getting some face-time on the issue,  the Fed is throwing money at the problem like nobody’s business, and the Wall Street Journal seems to be officially baffled. We’re down, but we’re up at the same time? What’s going on?

I’m not a professional financial anything, but I was square in the middle of the housing boom working as a title clerk for a company that has a brother mortgage brokerage on the other side of the coffeepot, both owned by the same guy. I don’t know much, but here’s my take.

The housing bubble is bursting, I think we all realize that. This current drunken wobble of the market seems to be directly caused by that. You see, the bubble grew because banks around then figured out that they could make a lot of quick cash by selling loans instead of making loans.

It used to be that banks would get a mortgage application from a person. They would review the person’s various numbers, decide to make the loan, and feed on the interest. If the bank needed to generate cash for more mortgages, they might sell old loans to other banks. During the housing bubble, it either became fashionable or legal to sell those loans immediatly to investors instead, but I’m not sure which is the case. The bank earned fees from the customer when they created the loan, and they made a commission from the investors when they sold the loan, and they eliminated massive costs down the line because they didn’t need to worry about maintaining the loan anymore. It’s pure, addictive profit, and I’m sure you can see where this is going.

Like junkies, the banks started selling loans hard and indiscriminately.  Since the bank wasn’t holding the mortgages, they could sell much riskier loans. The saying went that anything with a pulse could walk away with money, and it was absolutely true. There was a whole class of mortgages for people with no income. Banks began involving fleets of independent mortgage brokers, on commission, to sell money, and they sold hard. By and large, these guys (and they are mostly guys) are salesmen, not financiers, and we know that salesmen will do whatever it takes to make a deal that benefits them. Since sub-prime loans made the brokers more money thanks to higher interest rates and fees, and since brokers made big bucks when they could sell a loan for anything above the lowest interest rate available to a customer, unethical practices were rather inevitable.

Just a note, if you’ve ever bought a house, and had to pay a yield spread at closing, you were hosed. A yield spread is a fee to reward the broker for selling you a higher interest rate.  Nice, huh? I’d like to call it a stupidity tax, but it’s honestly just exploitation of uneducated consumers, and one of the most evil things I can think of.

I should also mention, Adjustable Rate Mortgages were at an all-time high. In case you don’t know, ARMs start out at sometimes comically low interest rates, and after a predetermined time, the interest rate goes (way) up and changes regularly after that. They’re attractive to the greedy and the uninformed, and often all that was offered to the poor. They moved like hotcakes.

The trick with ARMs is that you’re making a bet that interest rates will stay low. If you bought an ARM in the 80’s, your interest rate in the 90’s may well have adjusted down.  This isn’t the case right now. The Prime lending rate fell in 2001 from just under 10% to just over 4%. Right now, it’s at 8.25%. That’s a big difference. On top of that change, it’s very likely that the mortgage states that the rate will be prime plus a certain number of points. Now, the attractive promotional rate of a couple of years ago is starting to resemble a very big credit card.

Now that interest rates are up, and now that the ARMs are starting to adjust, people left and right are starting to default on their loans. A lot of people were honest victims of unethical business, but I have a hard time feeling too bad for the plight of humanity because consumer greed played a large part of it too. People didn’t take the time to do their homework on the loans they were taking, and they were blinded by dollar signs and hallucinations of McMansions. Sure, hundreds of thousands of people are well and truly screwed, but a significant portion of them did it to themselves.

And it’s only going to get worse. As people get foreclosure letters in the mail, they’re going to try to sell their houses fast. Some of them will succeed, and being motivated sellers, they’ll probably sell for less than they could have otherwise. This lowers property values. Some of them won’t be able to sell, and the house will be foreclosed on and sold by whoever holds the mortgage for whatever is left on the loan, more or less. This also lowers property values. With house prices going down, folks with ARMs who would like to sell their houses and get out of the loan will be less likely to get a price that will cover the loan balance, which puts them at risk for foreclosure. It’s a spiral and blah blah blah bad for the economy.

And this all brings us back to the stock market. Remember those investors who the banks were selling the mortgages to? Those mortgages ended up being bundled together into Mortgage-Backed Securities, which are a sort of bond. To horrifically oversimplify, if you take a whole bunch of mortgages, which is basically a giant wad of debt, and stir them up in a pot, when the home owners’ payments come in the negative numbers go up a little and the interest rises to the top as a profitable return. Whoever owns the MBS then hits the market and sells shares to investors, and MBS investments have shown up in mutual funds, pension plans, 401ks, and individual investors portfolios. These things were hip, man. Yet another way to get a piece of the real estate boom.

Now, can you imagine what happens in these MBSs when loans inside them go belly up? Not only does the future interest void, but the money that was originally loaned evaporates, too. A big chunk of that giant debt suddenly becomes unrecoverable, and profitability gets stomped on. Remember that the banks were rather indiscriminate about who they made loans to? Turns out that the investors weren’t real careful about checking the riskiness of the loans they were buying, either. The result is a direct vein from the housing market to the stock market.

So, a whole bunch of greed and stupidity is collapsing in on itself, and the housing market is bringing down the stock market in an unprecedented way, I think. And when one part of the market wobbles, investors in the rest of the market get squirrely. This isn’t going to resolve quickly. Until housing shakes out, everyone is going to be jumpy, and I’m not sure what the Fed can do to fix the foreclosures and falling prices.

At least, that’s what I think. If I got anything in there wrong, and I’m sure I did, let me know. (That goes for you too, Mom, if you’re reading.)

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Man, this turned into a big bummer. I was planning on writing about how happy I was that the market was falling right as I started investing, because I heart the long term.